With so much financial information coming at us each day, and at a time when everything seems to be changing, trying to stay on top of the terminology can be overwhelming. It can be a daunting task even to begin figuring out whether you, personally, need to pay attention to any of it. One topic that seems to surface a lot – maybe because it sounds so ominous – is “bracket creep.” We have had many investors ask us what in the world this is and, when they hear the details, what they can do about it.
The good news is that bracket creep alone probably won’t irreversibly derail your financial plan. But it can result in some costly and unpleasant surprises. Luckily, we can work to avoid it through sound tax planning and help you instead put your dollars to use in the ways most important to you.
What is bracket creep?
The term refers to income tax rates and your potential to “creep” into a new rate on the tax tables without knowing it, resulting in a startling tax bill when your file your tax returns. Tax tables work in a way that break your taxable income across layers, with the tax rate increasing at each additional layer. This progressive tax system means that every additional new dollar of income is taxed at the rate in the top layer in which you sit.
When your taxable income goes up, it’s usually because you have new sources of income, which can be a good thing. It may mean you got a raise, promotion or bonus at work. It may mean you started receiving Social Security or retirement income, or that your investments are earning more income. An increase in income may mean that you now have more money to spend or save. Sometimes, though, when your taxable income rises, the result isn’t necessarily more disposable income. But your tax bill could grow anyway if this new income pushes you into a new layer (and higher tax rate) on the tax tables.
What can you do about it?
First, layers in the tax tables (and their corresponding tax rates) are modified each year for cost-of-living adjustments. However, sometimes those increases are not enough, so bracket creep can occur anyway. Again, keep in mind that when you move up to a new layer on the tax table, it doesn’t mean all of your income is taxed at the higher rate in that bracket, only income in the new layer.
Understanding what bracket you are in can help you plan income and take advantage of any tax opportunities that may exist, especially in years that are unique due to a job change, marriage, divorce or other life event. The IRS has a useful tax withholding estimator on its website that anyone can use to look at their tax situation and help determine if any withholding adjustments are a good idea.
Another thing you may want to consider to reduce the risk of bracket creep is to increase or begin making contributions to your retirement plan at work or to an IRA. If your budget has the room to allow you to do this, it can help reduce your taxable income while also setting aside savings for your future.
In addition, the government’s COVID-19 and economic relief package – the CARES Act, which was passed earlier this spring – opened the door to new tax planning opportunities for some people, not to mention extending the due date for federal income tax returns to July 15, 2020. Among the areas that present some tax planning opportunities are:
- Required Minimum Distributions (RMDs) from retirement accounts were eliminated for 2020. Passing on this income, if that makes sense for your situation, could help relieve bracket creep. Even if you have taken your distribution for 2020, you may be able to put it back.
- Traditional IRAs allow earnings to accumulate tax-deferred while Roth IRAs allow earnings to accumulate tax-free. Because many IRA values have fallen with the markets, it may be an opportune time to convert a traditional IRA to a Roth IRA so the future growth then accumulates tax-free.
- The law introduced changes that impact certain charitable contributions and their tax treatment, which could create planning opportunities.
- Relief provisions dealing with student loan, mortgage and retirement accounts could help with cash flow if it is needed.
To say that 2020 will be unique for many of us is an understatement. The coronavirus and its fallout have been affecting people in many different ways, from their health and employment to their investments, all of which can in turn impact someone’s tax situation. With plenty of time left to plan in 2020, reach out to your wealth advisor and tax professional to review where you stand and take the necessary steps to help prevent any “creep” from sneaking up on you.
Jada Diedrich is a wealth advisor at Buckingham Strategic Wealth.
Beacon Hill Private Wealth is an independent, fee-only, fiduciary investment advisor providing evidence-based wealth planning solutions that simplify our clients' financial lives. Founder Tom Geoghegan, CFP®, MBA is also a member of the National Association of Personal Financial Advisors (NAPFA).
Important Disclosure: This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. Each individual person should seek independent tax advice from a tax professional based on their individual circumstances.
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